The Illusions of Entrepreneurship

The odds are against you: Why entrepreneurs are unlikely to succeed.

Jason ZaskyMar 12, 2008

Start your own company. Become rich and famous. Live the American dream. Happens all the time, right? That's the impression one gets from reading Fast Company, Inc., Entrepreneur, and any number of other business magazines. Tempted by the allure of being one's own boss and the potential for achieving spectacular success, every year millions of Americans launch new businesses, only to discover that being an entrepreneur is less glamorous and more difficult than they expected.

Enter Scott A. Shane, professor of entrepreneurial studies at Case Western Reserve University, who penned “The Illusions of Entrepreneurship: The Costly Myths that Entrepreneurs, Investors and Policy Makers Live By” (Yale University Press) to give would-be entrepreneurs an accurate picture of the realities of starting a new business. For those self-assured individuals who believe they know it all, Shane also developed an online quiz designed to test one's knowledge of entrepreneurship. “If you score 100 percent there is no reason to read the book,” contends Shane, “but if you score 40 percent … the information in the book may keep you from making decisions you'll regret later.”

Shane spoke with Failure about the myths of entrepreneurship and why it's so important to make well-informed decisions when contemplating a new venture.

How do you define entrepreneurship?An entrepreneur is defined as someone who starts and runs his or her own business. So entrepreneurship is the act of starting and running one's own business.

Who is the typical entrepreneur?The typical American entrepreneur is white and male, lives in a small city where he has lived his entire life, and starts a business with $25,000 of his own money. More often than not, the business is in a run-of-the-mill industry like retail or construction or involves providing a personal service to individuals. Typically he has worked for many years in that same industry.

Why are people getting inaccurate information about entrepreneurship?It's a couple of things. We have an ethos about entrepreneurship in this country. We like to think of it as being a part of American culture and something that we're very good at. So people tend to discount negative information when they read or talk about entrepreneurship. And individuals who engage in entrepreneurship are often over-optimistic about their own chances of success.

The media also plays a role. It's very difficult to write about the typical entrepreneur because he's not inherently exciting. What Google buys for a billion dollars is inherently interesting, so we get a lot of those kinds of articles. But people don't realize how incredibly rare stories like that are.

One of the things I point out in the book is that the odds of getting venture capital for a startup in the U.S. are worse than dying from a fall in the shower. Yet there are a huge number of articles devoted to venture capital—a disproportionate discussion of venture capital relative to its frequency.

Speaking of venture capitalists, how much of a role do they play in launching new ventures?It depends. They are funding 3,000 companies out of about 1.5 million startups in the U.S. every year. So in terms of numbers of businesses it is tiny. And in terms of dollars provided the venture capital community provides only two percent of the capital of new businesses in America. By comparison, banks are providing 16 or 17 percent, about eight or nine times as much.

But in terms of impact on the economy it's different because venture capitalists back the highest growth, highest potential businesses. If you look at the venture capital-backed startups in this country you find that the handful that have been created over the past 25 years account for 12 percent of the sales of businesses in the U.S. So venture capitalists are funding a tiny percentage of businesses and are providing a very small amount of the money, but the end outcome of the companies they fund is disproportionately large.

How can believing myths about entrepreneurship hurt one's prospects for success?Think about the kinds of decisions a person could make based on myths about entrepreneurship. Consider the odds of failure, for instance. We know from a variety of studies that 55 percent of new businesses will be gone in five years. But suppose you believe the myth that most businesses are successful. So you borrow money from a bank by pledging personal assets as collateral. It turns out that your business is just average and because it's average it fails and you lose your house. That's an example of how making decisions based on bad information can have a negative outcome.

In the book you assert that entrepreneurs tend to start businesses in industries with very high failure rates.There's a correlation that is quite remarkable in that the rate of startups in an industry and the rate at which startups fail in that same industry is correlated 0.77. People are most likely to go into industries where startups are most likely to fail.

Why do they do it? One reason is those industries are easy to enter. But because it's easy to enter a lot of people do so and it's very competitive.

Part of it might also be that people don't realize there's information out there about what industries entrepreneurs tend to perform better in. So people are gravitating towards industries they have a lot of information about, and those happen to be ones where there is a high failure rate.

What do successful entrepreneurs do differently from failed entrepreneurs?One thing they do is search for a good idea. The typical entrepreneur starts their business in the same industry as their previous employer to serve the same or similar customer with the same or similar products. Successful entrepreneurs try to serve an underserved niche in the marketplace and report spending a lot more time examining potential opportunities.

Other differences: The typical entrepreneur sets up a sole proprietorship but there is lots of evidence that corporations do much better on a variety of performance measures; the typical entrepreneur serves consumers but those who serve businesses tend to do better; and the typical entrepreneur competes on price but successful ones tend to use a different strategy like focusing on service or quality.

I could go on and on. The thing that is interesting is that because the typical person fails, that means that what most people are doing is not something you should benchmark.

How much does writing a business plan increase one's chance of success?It's hard to state a specific number because it's not an easily measured, discrete item. One can't interpret business plans in terms of number of pages or how many hours were spent on it. But we have evidence that a business plan increases the odds of survival by something like ten percent.

How successful is the typical entrepreneur?The majority of entrepreneurs are unsuccessful; close to two-thirds of businesses are gone within ten years. Of the minority that are alive after ten years the entrepreneurs that run them are earning only about two-thirds as much as they earned in their previous job. So the typical entrepreneur is not doing well. To get people who earn more than they earned working for somebody else you need to look at the top ten percent of entrepreneurs. The top ten percent are doing very well.

It almost sounds foolish to start a new business. Why do it?It's foolish in the sense that on average it's foolish. It's like why going to Las Vegas, on average, is a bad idea. The house wins. But if you have reason to believe you will be better than average it could be a good thing. If you have a really good concept and a lot of entrepreneurial talent, then it might be a good thing, but it's probably not a good idea for the average person. It's not that we shouldn't have entrepreneurship, it's that we have too many people doing it when perhaps they shouldn't.

There is another part of this, however. Most people don't start businesses to make money, they start businesses because they don't want to have a boss. We know that job satisfaction is higher for people who run their own businesses—so much higher that you have to pay them two-and-a-half times as much to get them to work for somebody else. What is happening is that a lot of people are becoming entrepreneurs in spite of the fact that they don't make as much money. So the people who believe they are going to get rich need to think carefully about what will make them end up in the top ten percent of entrepreneurs because that is what it is going to take.

The idea that we have too many entrepreneurs goes against conventional wisdom.Right. But if everybody became an entrepreneur then all the big companies that provide a huge amount of value would disappear because there would be nobody working for them.

For most people it is probably a better choice to go to work for a big company than it is to start a new company. And we have a lot of evidence that most people make that very choice. When the unemployment rate goes up more people start businesses because the opportunity cost goes down. If you are sitting at home watching television you may as well start a business—your cost isn't that high. But if you have a good job then starting a business makes less sense.

Why should we change our collective perception about entrepreneurship?For one thing, our collective perception is getting a lot of people to make decisions that they regret. People are starting businesses that lose money and end up failing. If you survey them afterwards they say they wish they hadn't started a new business. People are getting hurt out of ignorance.

Another reason is that resources are being wasted. A lot of the businesses that are started don't go anywhere. Those people would be better off working for someone else. Encouraging them to start new businesses is counterproductive.